Rating the Raters: Conflicts of Interest in the Credit Rating Firms

Abstract

ABSTRACTThe major credit rating agencies contributed substantially to the sub‐prime mortgage crisis by giving their highest rating (AAA) to most of the collateralized debt obligations (CDO) securities that were backed by these sub‐prime mortgages. Because the rating agencies are compensated by the issuers whose CDO bonds they rate, this relationship creates a prima facie conflict of interest, one that is compounded when the rating agency also consults for the issuers on designing the CDOs. While Congress and the Securities Exchange Commission investigate possible wrongdoing, various reforms have been proposed. This article analyzes these conflicts of interest and the cognate corporate governance issues. It then categorizes and critiques several of the reform proposals—which range in severity from requiring more disclosure to the suspension of the rating agency's license.